No, I don’t want the Fed to cut rates because that would give a hyper boost to the stock market. And no, I’m not calling for rate cuts because of the housing market, the sub-prime meltdown or the subsequent shutdown of the collateralized debt market.

Rather, I believe the Fed should cut rates immediately because that’s what the market has been trying to tell it for too long.

Take a look at the chart below. It compares the 90 day treasury rate (black) to the Fed funds rate (blue). As you can see, the Fed funds rate follows the market set short term rate.

But the Fed got out of step with the bond market sometime this spring. As the rate fell, the gap between the two became more and more obvious. The two have not been this out of step in a long time.

The collective vote of the market is loud and clear. No committee, no matter how esteemed and knowledgeable, can know as much as a diverse and free market.

So this is my crazy call: the Fed will (or rather should) cut rates sooner rather than later.

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Back in late 2006, I suggested that the FOMC was on hold for 2007, which at that point, was an out-ot-consensus view. I still think the FOMC is on hold. The Bernanke put, if there is one, has a much lower strike than the Greenspan put. He also does not rein in the hawks at the FOMC, as Greenspan did.

Cutting rates here would lead the dollar to fall, and inflation to rise. I doubt that it would help the markets much… you’d get a series of failing rallies, kind of like the 2000-2002 experience.

Babak, the bond market is in a flight to quality and simplicity. Yields for high grade debt have been falling, while yields for moderate (BBB) and junk grade debt have been rising. The yield curve has shifted to reflect a sooner likelihood of a rate cut, but we saw that earlier in this cycle as well, and it didn’t happen.

There is real significance to this, even if I don’t think the FOMC is going to loosen in 2007. Credit risk is getting repriced to levels that reflect the true risks taken on. Projects that don’t deserve financing are getting pulled, or taken down by investment banks that guaranteed financing commitments. The investment banks have pulled in their horns, and most parties have reduced risk tolerance for now. That may shift if there are no defaults in the near term… lenders will gain confidence, and the game might begin anew.